David Darst is Managing Director
and Chief Investment Strategist for the individual investor business
of Morgan Stanley. "The Art of Asset Allocation"
is possibly the definitive work on the principles
of asset allocation in investment portfolios.

David's book deserves a plug
firstly because it is good, but also because David has generously
donated the entire royalties from this book through the Morgan
Stanley Foundation to the families of the 13 Morgan Stanley employees
who died in the World Trade Center on Sept 11, 2001.

It was David who planted the
seeds of the idea for this article when he suggested that most
of the major problems facing the USA (and thus the world) commenced
with the letter "D." I have refined his idea
to produce the following list:

Most readers will be familiar
with the first 6 but will be puzzled by the last one, DEVOLUTION.
It is included because the first 6 problems, combined with the
likely Government responses, will probably lead to a situation
where one single investment criterion will become so important
that it will transcend all other factors in investment decisions.
That situation will lead to DEVOLUTION. We will return to this
later.

The first 6 problems have received
a great deal of coverage elsewhere and there is no need to regurgitate
them in detail here. These problems generally involve huge mind-numbing,
incomprehensible numbers of dollars. Those numbers continue to
grow so rapidly that they tend to be out of date shortly after
they are published. The following brief notes on the first
6 "D's" deliberately ignore these gigantic numbers.

The US Current account and
Federal Government DEFICITS have grown to chronic levels where
each deficit now exceeds 6% of the country's GDP. How will these
continuing deficits be financed? The answer, by creating increasing
quantities of electronic US Dollar credits.

The US DOLLAR will be under
downward pressure while these deficits continue. The lower the
US Dollar declines, the greater the pressure on those countries
that export to the USA. These countries will protect their markets
by invoking competitive DEVALUATIONS. This cannot happen in a
freely floating exchange rate system, but is effectively done
by foreign countries creating massive quantities of their own
currencies. These new foreign currency electronic credits are
then dumped on the foreign exchange markets, thus weakening their
currencies. In this way the American problem is exported to the
rest of the world.

DEBT of all kinds in the USA
has been reaching record high levels for decades and continues
to do so. This is the way the economy is stimulated in a fractional
reserve banking system. DEBT must continue to grow. A contraction
in DEBT will lead to those other unmentionable "D"
words, DEFLATION and DEPRESSION. This will not be allowed to
happen. New electronic US Dollar credits will be created to whatever
quantity is required to avoid this outcome.

DEMOGRAPHICS refers to the
imminent retirement of the Baby Boomers generation and the huge
unfunded liabilities that exist in Social Security, Medicare,
Pension Funds and other US programs that need to be funded. Several
books have been written on this subject. One of which is "Running
on Empty" by Peter Petersen. Those unfunded liabilities
will be funded, probably once again by the creation of
new electronic US Dollar credits to the extent necessary to meet
the unfunded liabilities.

DERIVATIVES have been the fastest
growing area in US finance over the past 15 years. The numbers
involved are truly mind boggling. About 25% of the Derivative
instruments in existence are Exchange traded items such as futures
and options. The other 75% are Over-the-Counter instruments,
privately created and traded between major financial institutions.
These tend to be extremely complicated transactions that are
often difficult to value. They rely heavily on their counter
parties in these transactions actually meeting their obligations
when they fall due.

There is a grave risk of counter
party failure in the Over-the-Counter derivative area. If one
major counter party goes bankrupt and fails to meet its commitments,
it could trigger a domino like collapse of major institutions
in the financial markets. The numbers involved are so vast that
there is potential to bring down the entire financial system
in the event of a major counter party default.

If this risk is readily discernible
to outsiders, then bankers and others involved in the OTC derivatives
must be acutely aware of the problem. Bankers are not stupid.
They are extremely clever, cautious people. So how could they
allow the OTC derivative situation to grow to such a massive
extent with all the concomitant risks involved?

One suspects that they know
something we don't. Do the major players in the market have
some assurance that there will be no counter party failure? Without
that assurance, the gigantic build up of OTC derivatives over
the past decade would surely have been unthinkable. Alternatively,
they must have deliberately built up the derivative market without
considering the size or risks involved on the assumption that,
as with past similar cases, the Federal Reserve and Federal Government
would combine and to come to the rescue of a failed major counter
party.

The OTC derivative market looks
like an accident waiting to happen. Already some lesser players
are showing signs of strain. How do the authorities rescue a
problem situation when it occurs? Again by creating electronic
US Dollar credits to the extent necessary to prevent a catastrophe.

The common thread that runs
through this brief summary is that when problems emerge in the
US financial system, the authorities will solve them by throwing
money at the problem, by creating new electronic US Dollar credits
whenever necessary and to whatever extent necessary. This is
not just a personal opinion. We have been told by no lesser personage
than Dr Ben S Bernanke, who is a member of the Board of Governors
of the Federal Reserve Board, that the authorities now have a
new tool, the electronic printing press, which will be utilised
when disasters threaten.

When the supply of something
is increased sharply relative to demand, the value of that commodity
will decline. If the supply continues to increase rapidly and
indefinitely, then that item will become worth less and less,
with the potential to finally become nearly worthless. This is
the Developing Disaster facing the US Dollar and the world. This
is the factor that could become the single most important criterion
in investment allocation decisions and possibly even for individual
financial survival.

When that point is reached,
the headline to this article: "The objective of investing
is to increase the purchasing power of capital," will
become ever more pertinent.

We can now return to the final
factor, the 7th "D," which is DEVOLUTION. Dictionary
definitions of the word DEVOLUTION include the following:

1. A passing down or descent
through successive stages of time or a process.
2. Transference, as of rights or qualities, to a successor.
3. Delegation of authority or duties to a subordinate or substitute.
4. A transfer of powers from a central government to local units.

It is the first definition
that is applicable here. Imagine an inverted pyramid of various
investment type assets where the least secure (and most prolific
assets) are in the very wide top layers. The inverted pyramid
then narrows down through layers of increasingly more secure
asset classes to the small point at the base which consists of
the most secure (and least prolific) assets. This is an idea
propagated years ago by John Exter.

The theory is that in times
of financial crisis investors will cause their investments to
devolve downwards (hence DEVOLUTION) through the different asset
class layers in the inverted pyramid as they search for greater
security. DEVOLUTION is thus a movement by investors out of riskier,
speculative asset classes into more secure ones. This is what
can be expected in the months and years ahead as the creation
of electronic US Dollar credits gathers momentum and faith is
lost in the US Dollar.

The assets in the most secure
category at the tip of the inverted pyramid are gold and silver
bullion, assets that have performed the function of protecting
wealth throughout the ages. In the layer above the precious metals
lie the companies that mine and hold large deposits of gold and
silver. The least secure assets in the envisioned environment,
which form the broad layers at the top of the inverted investment
pyramid, will be the electronic US Dollar credits and assets
or loans that are repayable in US dollars.

The DEVOLUTION of assets into
more secure investments is not just an esoteric theory. It is
already happening and can be observed in the actions of thinking
investors such as Warren Buffett, possibly the greatest investor
of the past century. Buffett has been gradually moving the assets
of his investment company, Berkshire Hathaway, into increasingly
more secure asset classes. He made headlines last year when he
moved over $20 billion out of US Dollar cash assets into foreign
currencies.

Buffett already has a stash
of silver bullion, so is clearly aware of the protective power
of precious metals. It is only one short further step for Buffett
to move out of foreign currencies (which will eventually follow
the path of the US Dollar) into gold bullion and precious metal
mining company shares, a move that seems logical and inevitable
in the circumstances envisioned above.

A move into precious metals
and their associated mining companies by a person like Buffett
would instantly change the public perception of this asset class.
If it is not Buffett, it will be someone else, as the logic of
doing this will become increasingly apparent to investors. Then
the devolution of investments down through the asset classes
of the inverted pyramid will truly gather momentum. The quantity
of precious metals and their associated mining company shares
is very limited while the quantity of electronic US Dollar credits
is infinite. It will be a question of "first come,
first served."

Disclosure and
Disclaimer Statement: In the interest of full disclosure, the author
advises that he is not a disinterested party in that he has personal
investments gold and silver bullion, gold and silver mining shares
as well as in base metal and energy companies. The author's objective
in writing this article is to interest potential investors in
this subject to the point where they are encouraged to conduct
their own further diligent research. Neither the information nor
the opinions expressed should be construed as a solicitation to
buy or sell any stock, currency or commodity. Investors are recommended
to obtain the advice of a qualified investment advisor before
entering into any transactions. The author has neither been paid
nor received any other inducement to write this article.